Description

Heckmann Corporation (HEK)

FDSO: 111mm

Net Cash: $50mm

EV: $594mm

Business

Heckmann Corporation ("HEK") is a services-based company focused on total water solutions (transportation, disposal, and treatment of fresh, frac, and produced water) for shale or "unconventional" oil and gas exploration with a strong presence in the Haynesville, and a burgeoning presence in the Marcellus, Eagle Ford, and Barnett shales. HEK's wholly owned subsidiary China Water & Drinks, Inc. ("China Water") produces and distributes bottled water products in the People's Republic of China. The link to the last investor presentation is here:  http://heckmanncorp.com/PressReleases/investor-march2011a.pdf

HEK was formed by Dick Heckmann in May 2007 as a SPAC to invest in water assets and raised $421mm in an IPO in November 2007. Prior to founding HEK, Mr. Heckmann restructured K2, Inc. where he doubled revenues and tripled profits in 4 years and sold the company to Jarden for $1.2B in 2007. Prior to K2, Inc, he was the founder and CEO of U.S. Filter, the largest water treatment equipment manufacturer in the US, which he grew from scratch to $5.0B in revenues and sold to Vivendi in 1999 for $8.2B.

In October 2008, HEK purchased China Water which was one of the fastest growing domestic bottlers of water in China as well as the largest bottler of water for Coca-Cola in China in a mostly stock transaction. Shortly after the acquisition, however, it came to light that the previous management team of China Water had committed fraud by inflating historical sales figures. Luckily, HEK did not fund the acquisition with cash and over time was able to expunge the majority of the shares given to the sellers. Since 2008, HEK management has worked diligently to right the ship so that by the end of 2010 China Water was fully Sarbanes-Oxley ("SOX") compliant and growing volumes >20% annually with Coca-Cola contributing 65% to China Water sales. For a more detailed account of the China Water incident follow the link below.

http://www.thestreet.com/story/10953579/1/dealmakers-long-trip-through-china-rto.html

After discovering the fraud both the sell-side and buy-side left HEK for dead. But in the meantime, the CEO has reassembled his U.S. Filter management team and has been using the cash from the SPAC to build a really exciting "water story" few investors have picked up on yet.

China Water

China Water sold 405mm bottles in 2009, 486 bottles in 2010 and is projected to sell over 575mm bottles in 2011 (Note that volume growth in 2011 is ~18% but ex divestiture of a Harbin plant, volume growth continues to be +20%). Approximately 65% of this business is currently with Coca-Cola, a low margin cambusiness, but gives China Water legitimacy and the potential for additional international business from other OEMs. That said, the company has been growing its own branded business (15% of sales) which generate ~2.0x the profits of its OEM (e.g. Coke) and private label businesses. Longer-term, management hopes to grow its own branded business to 50% of volumes which would drastically improve margins. Even today, China Water generates decent cash flow and can easily grow volumes 20% to 25% per year organically over the next five years due to China's insatiable demand for clean water. What's China Water worth?

Today revenues are approximately $0.06-$0.07 per bottle and management's conservative volume estimates for 2011 are 575mm bottles. Transaction multiples today for Chinese bottlers are 2.0-3.0x revenues and those transactions have been for lesser quality bottlers that are not SOX compliant. If we grew those figures at a 20-25% CAGR, China Water could be worth between $179-$275mm in a few years which discounted back at 10% is worth ~$134-$207mm today. The company is focused on realizing value for the asset and it seems reasonable to expect some type of monetization potentially as soon as within the next 6-12 months.

Water Solutions for Energy Development

With the remaining cash on the B/S from the IPO, Mr. Heckmann started making acquisitions and building pipelines in the Haynesville shale in mid-2009 after noticing the lack of vertically integrated companies that transport, dispose, and treat fresh, frac, and produced water for the E&P companies. HEK recently completed five additional acquisitions which close toward the back end of 2Q11 which substantially expands its presence in the Marcellus, Eagle Ford and Barnett.

By the end of 2011, HEK will own and operate 22 disposal wells with 340,000 barrels per day of permitted capacity, 650 trucks for hauling and disposal, and 1,050 frac tanks. HEK is also in the process of building out a 60-mile produced water pipeline (~100,000 barrels per day capacity) and a 40-mile fresh water pipeline (~60,000 barrels per day). The cost of the fresh water pipeline and 1/3 of the produced water pipeline is paid for and the return on investment is >40% at full capacity.

On the produced water pipeline, HEK makes roughly $1.50-$1.75 per barrel and EBITDA margins of 60-70% so around $1.06 per barrel using the midpoints. The remaining 240,000 barrels per day of disposal capacity will be trucked in at similar rates per barrel with EBITDA margins of 25-30% so around $0.45 per barrel. On the fresh water pipeline, HEK should make roughly $0.90 per barrel with similar margins to the produced water pipeline or $0.59 per barrel. So at 80% utilization, HEK has the potential to generate ~$72mm in EBITDA fully stabilized year 1 under $4.00 natural gas assumptions comfortably growing 20-30% per year for the foreseeable future. If natural gas prices were to go to $5.00-$6.00, the economics would be multiples of what has been laid out.  

Valuation

Near term, expectations are probably too low. HEK recently reiterated 2011 EBITDA guidance of $40mm. Given 1Q EBITDA of $6mm and 2Q guidance of $9-$10mm, the company is implying 2H EBITDA of ~$24mm or a run rate of ~$48mm which doesn't include the full benefit of the recently closed acquisitions, the 100 miles of pipeline in the Haynesville completed by 4Q, or any of the inevitable acquisition announcements in the back half of the year which the CEO telegraphed at a recent conference by saying: "And our projections of $150mm and $40mm assume first that those acquisitions come in the last three quarters are certainly not full year, and it also assumes that we wouldn't make another acquisition the rest of the year which is hardly likely."

Longer term, HEK is a company that will grow EBITDA from $50-$60mm to $110mm organically and will in addition to that be able to utilize its cash flow and prudently leverage the balance sheet to double or triple that EBITDA base in the next 2-3 years to levels easily north of $200mm. This compares to today's enterprise value of ~$424mm ($594mm minus midpoint of China Water's valuation of $170mm).

From a valuation standpoint, historical comps in the water industry indicate that 12-15x EBITDA are reasonable. For example, U.S. Filter, a company Mr. Heckmann founded and grew to $5.0B in revenues, was sold to Vivendi in 1999 for $8.2B or ~14-15x EBITDA. In a more recent transaction (March 2011), Sulzer AG purchased Assa's waste water pump for 12.8x EBITDA despite the fact that the company is only projected to grow 5% this year. On this range of reasonable assumptions HEK could sell for $15.00-$20.00 per share or more.

Clearly, the growth profile of HEK and the valuations assigned to the water industry suggest that HEK could be a multi-bagger from here in almost all scenarios. Given Mr. Heckmann's age (67 years old) and his history of building up companies and selling them profitably for his shareholders I expect that he will sell HEK at a hefty multiple to one of the many potential strategic buyers out there within 3 years or so.   

Warrants

Some investors are concerned about the ~51mm warrants outstanding (ex "founders' warrants which won't vest unless the stock is above $11.50) which have a $6.00 strike price and expires on November 9, 2011. But under the cashless option outlined in the IPO prospectus, the worst case dilution with the stock at $8.00 a share or 38% above today's prices would only dilute the share base by ~10%. Frankly, even if the warrants were fully exercised on a cash basis, there would be nominal impact on an enterprise value basis because of the cash exercise which could be used for additional accretive acquisitions.

HEK's valuation case is based on roughly $4.00 natural gas where it is still not profitable for many E&P companies to drill. However, some energy analysts argue that natural gas prices are set to rise over the next 12-24 months due to the demand picture getting stronger (http://www.ngvc.org/pdfs/NATGASAct2011.pdf) and the supply declining as many E&P companies reduce drilling capacity to pursue more profitable liquids drilling in "oilier" shales. If and when natural gas prices rise to $5.00 or $6.00, drilling would become profitable for many more E&P companies and HEK's volumes and pricing power would increase dramatically as each new well requires ~3-5mm gallons of water and shales such as the Haynesville have a moratorium on disposal wells (Note: HEK owns ~60% of the disposal capacity in the Haynesville). The produced water has to go somewhere!

An overview of the Barnett shale can give investors a sense for what the Haynesville (and the Eagle Ford and Marcellus) could achieve given higher natural gas prices. The Barnett shale currently has ~13,000 shale wells vs. the Haynesville shale, which only has ~1,000 wells in production with another 1,000 permitted despite greater estimated gas reserves than the Barnett. In this case the upside to EBITDA is not linear but exponential as the operating leverage and pricing power magnify the earnings growth in relation to volume growth.

LNG Trucks

HEK recently placed the largest order (200) of liquefied natural gas ("LNG") trucks by a U.S. customer with Peterbilt Motors with fueling services handled by Encana. The significance of this transaction is two fold. One, the LNG trucks while initially more expensive will significantly reduce the life cycle operating cost of fuel (e.g. natural gas is about 1/3 the cost of a gallon diesel equivalent for trucks), increase the average operating life of the vehicle, and typically delivers payback in less than 2 years. So clearly, from a cost and margin perspective the use of LNG trucks should be very beneficial to HEK's trucking operations going forward while lowering green house gas emissions by up to 30%.

Two, less obvious but more important over the long-term is that HEK's use of trucks that run on natural gas gives new E&P customers more reason to use HEK's services over other fluid management companies running their trucks on diesel. In fact, the CEO said interest in HEK from new E&P customers off the LNG truck news has been extremely strong. This should be a competitive advantage for HEK going forward.

http://heckmanncorp.com/PressReleases/encana-20110405.pdf

Risks

• 1. Key man risk - Dick Heckmann
• 2. Major restrictions on fracking in the US
• 3. Environmental issues/litigation
• 4. M&A integration

Catalyst